Moving Forward with Bipartisan Tax Policy

By Robert Carroll, John E. Chapoton, Maya
MacGuineas, and Diane Lim Rogers[1]

U.S.
tax policy is urgently in need of reform. Our tax system is overly complex and
has failed to keep pace with changing economic conditions. The current economic
crisis has led to an escalating budgetary shortfall, which will exacerbate the
already significant fiscal challenges facing the country. Moreover, looming
changes written into the tax law will require Congress to make major decisions
regarding the tax code. On December 31, 2010, most of the tax cuts passed in
2001 and 2003 (“the Bush tax cuts”) will expire. In the meantime, the
Alternative Minimum Tax will fall on tens of millions more American families. And
the federal estate tax is scheduled to disappear completely in 2010 before
reappearing in 2011. If these changes were permitted to take effect, which is
unlikely, they would lead to sudden and significant changes in effective tax
rates, after-tax wages, returns to capital, and the distribution of the tax
burden. Congress needs to act, not simply to move towards a more stable tax
system but to create a tax system adequate to the demands of the
twenty-first-century economy.

Under
current law, the tax system is also set to raise more revenue. Since the end of
World War II, federal revenues have averaged roughly 18 percent of GDP. They are
expected to fall to 17.5 percent of GDP for fiscal year 2010 (in large part due
to the current economic weakness) and then rise to 19.5 percent in fiscal year
2012, the year after the Bush tax cuts expire, and to 20.2 percent by 2018.[2]
These increases may be welcome to some because they will bring revenues more in
line with federal spending, which has averaged 21 percent of GDP over the past
25 years. Others will argue that spending should be reduced to match the
historical revenue average.

Regardless
of whether the tax cuts are extended, the gap between spending and revenues is
projected to increase dramatically in the coming decades due to the effects of
an aging population and rising per capita health care costs. Whatever
disagreements there may be between those on the right and those on the left
about the appropriate size of the federal government, the “correct” level of
revenues is that which adequately covers the cost of government spending
programs—if not year by year, then over the longer run. The unavoidable
economic costs of raising revenue can and should be minimized by creating a tax
structure that tries to minimize inefficiencies.

There
is also a difference of opinion along the political spectrum over how
progressive the tax code should be. Currently, the top 20 percent of earners
pay nearly 75 percent of all federal taxes, while the lowest 20 percent pay
only 0.4 percent.[3] Many
left-leaning observers think the tax code should be more
progressive—particularly in light of growing income inequality in the United
States. Others on the right argue that there is already a tremendous amount of
redistribution in both the tax and spending sides of the budget and that the
negative incentives and distorting effects resulting from additional levels of
progressivity could have a harmful effect on the economy and on living
standards.

Federal
policymakers face a choice: they can either continue to operate in a “reactive”
mode, proposing tax legislation haphazardly, resorting to temporary fixes, and
acting hastily when tax legislation is due to expire, or they can take a
“proactive” stance, instituting farsighted reforms that will lead to an efficient
and fair tax system for the long term.

Although
the authors of this paper have divergent viewpoints as to the appropriate role
and size of government, we agree that the current tax system is inadequate: it
raises revenue inefficiently and is not well equipped to handle the challenges of
the twenty-first century economy. We agree that the federal government should
take the following steps:

Create a more
transparent and straightforward tax code

Promote
saving by shifting toward a progressive consumption tax

Rethink tax
expenditures

Update U.S. business
income taxes

Implement an
environmentally motivated tax policy

We
believe that a productive discussion of tax reform must start where tax and
budget policy considerations intersect. We agree on a number of changes that
should be made to the tax code to improve its efficiency and transparency. And,
most importantly, we believe tax reform has to be undertaken on a bipartisan
basis if it is to be politically acceptable, economically sensible, and long
lasting.

A Bipartisan Tax Policy

In
thinking about how the tax system should be reformed, we first need to remind
ourselves of the major goals of taxation: to raise a given amount of revenue in
a manner that is as efficient (least economically distortionary), as fair (in
terms of the distribution of the tax burden among different types of people),
and as simple (in costs of administration, enforcement, and compliance) as
possible. Given the current fragility of the U.S. economy, we might add that
the tax system should also promote both short-term economic stability and
long-term economic sustainability.

Despite
our diverse perspectives on fiscal policy, we believe that achieving bipartisan
tax reform is possible by adhering to the following broad principles and
general prescriptions:

Stimulate, But Don't Squander. When it comes
to tax policies pursued in the name of short-term "fiscal stimulus,"
the rule should be "first, do no harm." Countercyclical fiscal policy
designed to stimulate demand-side economic activity should be pursued with
consideration to how it will affect prospects for longer-term, supply-side
economic growth. Stimulus that is or becomes permanent needs to meet clear
long-term objectives and not be a backdoor mechanism for implementing permanent
deficit-financed policies.

Broaden the Base, Lower the Rates. Given the
severe fiscal challenges confronting the nation, it is critical that we reform our
tax system to provide a more efficient and reliable source of revenue. This
calls for a broadening of the tax base in exchange for lower tax rates in
general.

Reduce Economic Distortions Caused by Taxes. For any given
amount of revenue, achieving more uniform taxation of economic activity—by filling
in the “holes” in the existing tax base and creating a more level playing field
between the various forms of economic activity—will improve the economic
efficiency of the tax code and reduce the distorting effects of taxes on
household and business decisions.

Encourage National Saving. We could take an
incremental approach to improving our national saving rate by creating better
incentives within the existing tax system. Given our very low national saving
rate, however, we should consider taking bolder action, moving our hybrid income/consumption
tax system toward a full-fledged consumption-based tax, which is inherently
less biased against saving.

Make the System More Transparent, Reducing
Avoidance.
The broader the tax base and the fewer the special preferences given to certain
types of businesses, individuals, or activities, the simpler the tax system
will be to understand and comply with, and the more likely it will be perceived
as fair. The more transparent the tax system (and the more difficult tax
avoidance is to conceal), the more trust taxpayers will have in government, and
the more willing they will be to pay their taxes.

Maintain the Progressivity of the Tax System. Although income
inequality has certainly grown over the past several decades, we are not able
to define an “appropriate” level of fairness regarding the distribution of the
tax burden. What we can say is that the current tax system is progressive by
any objective standard and that achieving additional progressivity through a
more graduated tax rate schedule carries with it real economic costs. Given the
significant increase in income inequality in recent decades, efforts to make
the tax code more progressive should be undertaken with these costs in mind.

Policy Recommendations

Create a More Transparent and
Straightforward Tax Code

An
essential goal of tax reform must be to create a tax code whose principal
purpose is to raise the revenues needed to support the federal government in a
relatively straightforward and transparent manner. Such a tax code would be
much simpler than the current tax code and therefore more easily understood by
the taxpaying public (in principle if not in detail), and it could be designed
to expose tax avoidance or evasion, thus possibly reducing the “tax gap.” This
would engender more confidence on the part of taxpayers that the system is
basically fair—that others are paying their share and avoidance or evasion is
being detected. Increased respect for the tax system is critically important to
the health of our democracy since, aside from voting, paying taxes is the only
direct contact most Americans have with their government.

Any
tax system will affect economic activity, but the effects should be at the
broadest possible level—encouraging overall investment versus investment in a
particular type of activity, saving generally versus savings of a particular
type, and charitable giving in general versus giving to favored causes.

Much
of the complexity and opaqueness of our current tax code comes from tax
expenditures (which we address below). A tax code that favors particular
industries or sectors of the economy, or particular social goals, increases
economic distortions. It also undermines respect for the tax system and greatly
complicates its administration. A more transparent and simpler tax code could
significantly increase the stability of the tax system, making it a more
reliable source of revenue. Just as important, a more stable and dependable tax
system would allow businesses and individuals to plan their finances with
greater certainty.

Further
policy changes are needed to improve compliance. Ours is a self-assessment tax
system, which means that taxpayers compute and report their own taxable income
and tax liability. For the most part, this task is completed with no oversight
or review by the IRS. Almost all tax returns are accepted as filed. Complex and
arcane tax provisions have led to a dramatic and well-publicized increase in
the number of avoidance or evasion techniques promoted or aided by tax
professionals of all stripes. Tax reform should not only reduce the complex
provisions that invite such schemes but also clarify the responsibilities and
duties of tax professionals.

For example, where a taxpayer is penalized for engaging in a
structured tax avoidance scheme, a similar penalty should be imposed on the
outside advisors and promoters. More
broadly, the existing ethical rules published by the Treasury Department
(Circular 230) should impose clear duties on tax professionals to investigate
the facts supporting unusually large tax benefits claims, much like the SEC
requires of counsel filing registration statements on behalf of clients.

Finally,
action is required to deal with the Alternative Minimum Tax (AMT) and the
upcoming expiration of the Economic Growth and Tax Relief Reconciliation Act of
2001 and the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (the
Bush tax cuts). There appears to be a clear political commitment to altering
the AMT. Congress should end the practice of passing temporary annual patches
and permanently reform the tax (or eliminate it completely) in a revenue
neutral manner. One option would be to eliminate the AMT in conjunction with
repeal of the current deduction for state and local taxes. Congress should also
determine which of the expiring tax cuts it plans to keep in place and make
them permanent in a revenue neutral manner. Given the large sums at stake, and
the other significant changes that will have to be made to the rest of the
budget, paying for these changes might be more effectively accomplished as part
of a broader tax and spending reform program.

Promote Saving through
the Tax Code by Moving Toward a Progressive Consumption Tax

One
of the economically harmful characteristics of the current income tax is that
it penalizes saving in favor of consumption. The tax penalty on saving reduces capital
accumulation. When workers have less capital to work with, they become less
productive, which lowers real wages throughout the economy relative to what
they would have been. Research suggests
that a shift to a consumption-based tax[4]
could increase the size of the U.S.
economy by as much as 9 percent in the long run, although some studies show smaller
gains.[5]
This is the main reason many economists have long embraced a shift toward
consumption-based taxes.

It
is the case that a consumption tax needs to be imposed at a higher tax rate
than an income tax. This is a reflection of the larger tax base under an income
tax, which includes the return to saving, while a consumption tax does not. But
this does not mean that the higher tax rate under a consumption tax is more
distorting, nor that that the higher tax rate erodes all of the economic
benefits of taxing consumption. Indeed, as a general rule, a consumption tax
that raises the same amount of revenue as an income tax will generally be less
distorting and more conducive to economic growth.[6]

Nevertheless,
a shift toward a consumption-based tax has raised several concerns. First, flat-rate
consumption taxes are regressive because lower-income households tend to
consume most of their income, while higher-income households do not. Second, a
consumption tax raises serious transition issues because it imposes a one-time,
lump-sum tax on existing capital. This may raise important intergenerational fairness
issues because the elderly tend to hold a disproportionate share of the capital
stock.[7]
But eliminating that transitional wealth tax also would largely eliminate the
efficiency advantages of a consumption tax.

There
are ways to improve the regressive design of certain consumption taxes. The
2005 President’s Panel on Reform of the Federal Tax System designed a
distributionally neutral Bradford X-tax that
imposed progressive rates on a consumption base. The X-tax imposes a business
tax level tax on a firm’s cash flow with a deduction for employee compensation
and a household level tax on compensation.
The bifurcated structure of the tax allows progressivity through a
graduated tax schedule on workers’ compensation. The Tax Panel also retained many of the tax
preferences of the existing income tax, while refocusing their benefits toward
low-income households. As the existing preferences reduce the tax base by
roughly 40 percent relative to a comprehensive consumption tax base, there is considerable
room to address progressivity.

The
economic case for moving toward taxing consumption rather than income is convincing,
though we believe it is only politically viable if is distributionally neutral.
We see two possible approaches for shifting toward a consumption tax while
stopping short of replacing the entire federal income tax system. First,
changes could be made to the existing tax base to further reduce the tax on the
return to saving and investment. An often underappreciated feature of the
current tax system is that it is a hybrid income/consumption system. Tax-free
savings accounts (e.g., individual retirement accounts, 401(k)s, and defined
benefit pension plans) and accelerated depreciation introduce substantial
elements of consumption tax treatment into the current tax base. Roughly 35
percent of household financial assets receive consumption tax treatment, and
the effective marginal tax rate on business investment is only 25 percent, as
compared to the 35 percent statutory tax rate.

Second,
a consumption tax, such as a value-added tax (VAT), could be implemented with
the revenue used to reduce the distorting features of the current income tax. For
example, the Treasury Department estimates that a value-added tax of between 5 to
6 percent would raise enough revenue to replace all business income taxes. Alternatively,
the revenue from the VAT could be used to fund a combination of deep reductions
in the corporate tax rate and reductions in the double tax on corporate
profits, and to address the regressive nature of such a tax through changes in
the income tax base. Transition relief is not a crucial issue because the
changes envisioned would either be incremental or involve a relatively small
consumption tax.

Rethink Tax Expenditures

Tax
expenditures—which in many instances may be described as spending programs run
through the tax code—are one of the fastest-growing areas of the budget. The
many tax credits, deductions, exemptions, and exclusions make up a huge portion
of government-directed resources, and are one of the areas of the budget most
in need of reform. Indeed, as shown in Figure 1, the various special provisions
reduce the size of the tax base by nearly 45 percent relative to the comprehensive
income tax base.[8] Repeal
of all of these special provisions would allow a 34 percent across-the-board
reduction in tax rates.[9]

Tax
expenditures are typically used to encourage certain types of
behavior—everything from saving to having children to home ownership. Before
the 1986 tax reforms, tax expenditures were mainly directed toward
corporations. Now, they are largely directed toward individuals and in support
of social policies. Tax expenditures appeal to politicians because they can
claim that they are cutting taxes while achieving desirable social outcomes and
economic goals, but they have many shortcomings.

First,
they are extremely costly and greatly complicate the tax code. The close to 200
tax breaks listed in the federal budget cost the government close to $1
trillion annually in lost revenue—in some years they cost more than the entire
discretionary budget. And it is the many tax breaks, rather than the tax rates,
that make the tax code so difficult for taxpayers to navigate.

Second,
when tax expenditures are created, they generally do not receive the same level
of scrutiny that a comparable spending program would. The focus is almost
entirely on the cost and distribution of the tax break, not on the more fundamental
questions of whether there is a role for government in this type of program or whether
the incentive is the most effective means for achieving a given goal. Further,
once these tax programs are in place, they do not receive the same level of
oversight as other spending programs. So while Department of Housing and Urban
Development programs are subject to oversight and must be reauthorized on a
regular basis, the home mortgage interest deduction and other housing programs
that are run through the tax code do not receive nearly the same level of
scrutiny.

Finally,
most tax expenditures are regressive. Those that are designed as exclusions, exemptions,
or deductions disproportionately benefit higher income taxpayers because of
their higher tax rates. Although this regressivity at the margin is more than offset
by the overall progressivity of the tax system, most voters (and many
politicians) are unaware that it exists.

More
to the point, many of these provisions shrink the size of the tax base, accrue
disproportionately to higher-income individuals, require higher tax rates
generally to raise the same amount of revenue, and require a more graduated tax
rate schedule to achieve a given distribution of the tax burden. These high tax
rates, which distort economic decision making and waste economic resources, are
needed to “pay for” tax expenditures whose benefits are often dubious. The
ability to pass off spending programs as tax cuts gives legislators an
incentive to craft government programs in complicated, nontransparent,
regressive ways without the normal level of scrutiny or oversight.

We
believe that reforming the system of tax expenditures—eliminating many and
reformulating others—would vastly improve the tax code. A number of tax
expenditures are in particular need of reform.

The
exclusion for employer-provided health insurance, for instance, exempts employees
from paying taxes on the value of the health insurance they receive from their
employers. This policy amounts to a tax subsidy averaging roughly $350 billion
a year through the next decade—more than 10 percent of federal revenues.[10]
It would be desirable to either reduce the value of the exclusion—a policy
supported by economists on both the left and the right—or eliminate it
entirely. The current policy creates an incentive for employers to provide too
much compensation in the form of health insurance and too little in the form of
basic wages, which are taxed. It favors those who receive health insurance from
their employers over those who purchase it on their own. And it ties up
resources that could be better utilized elsewhere within the health care market
or in other areas.

We
also favor capping or reducing the home mortgage interest deduction. The
current deduction, which allows homeowners to deduct the value of their
interest payments on mortgages of up to $1 million, distorts economic decision
making by favoring housing over other forms of consumption and investment, and homeowners
over renters, and by encouraging the purchase of larger homes.[11]
Some of the benefits may also be passed along—though higher prices—to
homebuilders and mortgage brokers—explaining why they so actively lobby to save
this tax deduction. Although changes would have to be phased in, with
particular sensitivity to the current housing situation, bringing the value of
the home mortgage interest deduction down from the $1 million level to
something closer to the average house value in the United States would
eliminate many of the existing distortions.

It
would also be desirable to transform a number of existing progressive
exemptions and exclusions into tax credits. For example, turning existing provisions
that are structured as tax deductions for education, or the personal exemption,
into tax credits would mean that all taxpayers would receive the same benefit
regardless of their level of income.

Overall,
tax expenditures should be treated more like spending programs. Those that are
outdated or are no longer achieving their purposes should be eliminated. There
are many overlapping programs that should be consolidated and redrawn. There
will certainly be disagreement about whether to use the freed-up revenues to
offset the costs of new spending programs, lower other taxes, or reduce the
deficit, but there is little doubt that reforming and reducing the number of
tax expenditures would improve the basic structure of the tax code.

Update U.S. Business Income Taxes

The
U.S. business tax system is also in need of reform. U.S.
business taxes are increasingly out of line internationally, which may affect
the competitiveness of the United
States and its attractiveness to investors. In
the mid-1980s, the United States dramatically reduced its statutory corporate
tax rate and became, by some standards, a low-tax-rate country. However, most
other countries have since reduced their corporate tax rates, leaving the
United States with the second highest statutory corporate income tax rate among
member nations of the Organisation for Economic Co-operation and Development
(OECD). Moreover, other countries continue to reform their business tax
systems. Nine OECD member nations—including Canada, Germany, the United
Kingdom, Italy, Switzerland, Spain, New Zealand, and the Czech Republic—lowered
their corporate tax rates between 2007 and 2008.

This
trend is not limited to the statutory corporate tax rate. Indeed, the decline
in the statutory corporate tax rate abroad is emblematic of broader changes in
foreign business tax systems. More comprehensive measures of tax rates, such as
the effective marginal tax rate,[12]
which include other aspects of business tax systems such as the value of tax
depreciation schedules and investor-level taxes, tell a similar story (see Figure
2). (The rate at which investment is written off or depreciated, investor level
taxes, and reliance on consumption taxes, also affect a nation’s
competitiveness.)

Relative
to the large developed economies of the G-7 nations, with which the United States has substantial trade flows, the United States
has an effective marginal tax rate on investment well above the average. For
the broader group of OECD nations, which includes a number of nations with
smaller economies, the United
States has an effective tax rate at about
the average. But what is particularly alarming is the trend depicted in Figure 2,
where the relative position of the United States has deteriorated. While
the effective marginal tax rate on investment has fallen on average by 30
percent to 40 percent elsewhere, it has remained largely unchanged in the United States.[13]

Although
it remains unclear precisely to what extent corporate taxes affect real wages
and living standards, current research suggests that real wages are sensitive
to corporate taxes. The intuitive thinking behind this research is that taxes
tend to be borne by the least mobile factor of production (e.g., labor or
capital). In the global economy, capital is highly mobile, while labor is not. According
to a study by the Congressional Budget Office, in an open economy framework as
much as 70 percent of the corporate tax may be borne by labor.[14]
Another empirical study suggests that between 45 percent and 75 percent the
corporate tax is likely borne by labor.[15]
Other studies show that the countries that have reduced corporate tax rates the
most have tended to have the largest gains in real wages.[16]
Thus, a substantial share of business taxes tends to be reflected in real wages
rather than in the return to capital. Corporate tax rates have the effect of
reducing capital accumulation, which lowers labor productivity and, ultimately,
real wages and living standards.

The
lesson for us is that the United States should place less emphasis on business
income taxes for financing government. Policies that lower the effective
marginal tax rate on investment the most per dollar of revenue may well provide
the biggest “bang for the buck.” Faster write-off of business investment, which
limits tax relief to future investment and to the expected normal return, may
be the most economically efficient policy. But, lowering the statutory
corporate tax rate, which reduces the tax on the return to both new and existing
investment, and on the full return to investment, may also reduce incentives
for firms to shift profits and expenses across countries to minimize their
taxes.

More
uniform treatment of business activity would also help improve economic
performance. When one type of investment is taxed more heavily than another,
capital flows to the low-taxed activity. Unless there are clear policy
objectives and economic benefits, capital will not be allocated to its most
productive use. Nonuniform treatment arises in a number of areas under the
current business tax system. First, there are numerous tax provisions that
provide special tax treatment to specific types of activities. These special
provisions narrow the tax base and require higher statutory tax rates generally.
A recent Treasury study found that the top statutory tax rate could be reduced
from 35 percent to 31 percent by repealing all of these special tax provisions.
Retention of any of these special provisions should require that a clear and
convincing case be made as to their economic benefits.

Second,
the U.S. tax system imposes a double tax on equity-financed corporate
investment. Corporate income is first taxed at the corporate level and then
again when either paid out to shareholders as dividends or retained and later
realized as capital gains by investors. As shown in Table 1, this double tax
leads to substantially high effective marginal tax rates in the corporate
sector (29.4 percent), compared to similar investment in the noncorporate
sector (20 percent). The result is a tax bias against investment in the
corporate form and a misallocation of capital between the corporate and
noncorporate sectors that reduces output. The double tax also affects corporate
dividend policy, which can have important implications for corporate
governance.

Most
developed nations have provided relief from the double tax by integrating their
individual and corporate tax systems in various ways.[17]
The United States
took a partial step toward reducing the double tax in 2003 by lowering the
taxes on dividends and capital gains. Nevertheless, a substantial double tax
remains that could be addressed by further reduction in dividends and capital
gains tax rates or some other equivalent approach.

Third,
and related to the double tax issue, is the very unequal treatment of debt and
equity finance under the U.S. tax system. While the return to equity-financed
investment may be taxed once, or perhaps twice if the investment is made
through the corporate form, as shown in Table 1, the return to debt-financed
investment is subject to a negative effective marginal tax rate (that is, it is
subsidized). Why do the negative effective tax rates arise? First, interest
expenses are deductible at the business level. Second, even though interest
income is fully taxable to individuals, by some estimates roughly 50 percent of
debt holders are tax exempt or lightly taxed (e.g., pension plans or other
tax-free saving plans/accounts, or foreigners). The result is a very
substantial tax bias toward debt-financed investment and against
equity-financed investment. This bias leads to a misallocation of capital and
may increase the risks to the economy. This may be a particular problem during
periods of economic weakness, such as during the current financial crisis,
where highly leveraged firms are more likely to be susceptible to bankruptcy
and financial distress.

Substantial
changes are needed to remedy these imbalances in the U.S. business tax system.
We should consider lowering the corporate tax rate, broadening the tax base and
permitting faster write-offs of business investment. A lower corporate tax rate
would also reduce the tax bias toward debt-financed investment, and the
distortion between investments made in the corporate and noncorporate sectors. Restricting
the deductibility of interest would more directly address the imbalance between
debt and equity finance.

Replacing
the corporate income tax (or all business income taxes) with a VAT-type tax
would simultaneously address all of these imbalances. The corporate income tax
could be replaced with a 5–6 percent value-added tax.[18]
This approach could dramatically lower the business tax rate: the statutory tax
rate would fall from 35 percent to the 5–6 percent tax rate on a firm’s cash flow,
and the economy-wide effective marginal tax rate would fall from its current
level of 17 percent to 8 percent.[19]
It could also eliminate all special tax provisions and would have the effect of
allowing all business investment (i.e., equipment, structures, inventories, and
land) to be expensed or written off immediately. Finally, a value-added tax would
also equalize the tax treatment of debt and equity by removing all financial
transactions from the tax base (i.e., both interest income and interest
expenses).[20] Alternatively,
a partial approach could be taken, with a 2 percent to 3 percent VAT replacing
half of current business income taxes.

One
of the criticisms of this approach, however, is that a value-added tax would
also deny the deductibility of wages and other employee compensation at the
firm level, which would directly increase the tax on labor. This is one of the
reasons that value-added taxes are viewed as regressive. However, if business
income taxes do in fact reduce real wages, this criticism may be overstated
because one tax borne by labor would be replaced by another tax also borne by
labor.

Implement an Environmentally Motivated
Tax Policy

In
addition to creating a tax code that is more economically efficient, with a
broader base and lower rates, we believe we should generally treat different
forms of economic activity more uniformly by reducing the “holes” (exemptions,
deductions, and credits) in the existing income tax base that distort economic
decision making (see the discussion of tax expenditures above).We can also
think “outside the income tax box” by adding items and activities to the
taxable base in ways that would allow their taxation to actually enhance,
rather than reduce, the efficient allocation of resources. It is under this second
category that environmentally motivated taxes fall.

Nearly
all economists, of all political and ideological persuasions, agree that in
some special cases where there is private market “failure” government policies
that intentionally alter relative prices can improve the allocation of
resources. In the case of activities generating “negative externalities,” a
“corrective tax” on such activities can internalize the social costs that are
otherwise external to private-market decisions; i.e., the tax can “correct” the
mismatch between private and social marginal costs.

Many
environmentally harmful activities produce negative externalities, because such
activities degrade the quality of public goods, or generate public “bads,”
without imposing a corresponding private cost or charge on those engaging in
the activities. Environmental quality is “consumed” but goes unpriced; as a
result, relative to what would be optimal for society, excessive degradation of
environmental quality occurs. Because the adverse consequences of
environmentally harmful activities typically stretch far into the future over
many generations, another reason social costs exceed private costs is because
most private-market decisions are shortsighted and do not account for costs and
benefits over such a distant horizon.

A
particular type of “corrective tax” that has been held in high regard among
economists for many years, and has more recently gained the interest of
policymakers, is the carbon tax. Emissions of carbon dioxide (CO2) contribute
to global warming (a public “bad”), but the private market underprices products
with a high carbon content. A tax based on carbon content could help align
social ends with private costs, leading to a more efficient mix of energy
consumption, reduced carbon dioxide emissions, and a slowdown in global
warming. Such a tax would also have a potentially broad base and therefore even
at relatively low rates could raise substantial amounts of revenue that could
be used for deficit reduction or reducing inefficient taxes.

Creating
a market for carbon, whether labeled a “tax” policy or a “permits” policy, is
our recommended approach to environmentally motivated revenue policy. In the
last (110th) Congress, significant progress was made on bipartisan legislation
for a carbon cap-and-trade program, where permits for the right to use
carbon-based fuels (and emit CO2) would be distributed to producers
(either free or by auction), and a tradable market for the permits would create
a market price on carbon. Note that an auctioned-permits policy is equivalent
to a carbon tax policy if the quantity of auctioned permits is set so that the
market-clearing price is equal to the size of the tax, and if the auction
proceeds go to the government. In practice, there will be uncertainty about how
to set either the “right quantity” or the “right price”: the tax policy must
set the price, and the permits policy must set the quantity. Under either
approach, these are policy choices that can be adjusted along the way. We think
it is essential not to give away too much of the value of the new carbon market
to producers, which would both eliminate the potentially valuable uses for the
revenue (i.e., reducing other distortionary policies) as well as limit the
government’s ability to adjust the policy’s distributional effects.

Of
course, designing and implementing a broad-based carbon tax is uncharted
territory for the United States and in fact for the rest of the world, especially
with respect to the trade-offs involved in setting the tax base (between
comprehensiveness and administrative ease) and scheduling/phasing-in the tax
rates (between economic effectiveness versus political palatability).[21]
Some experts prefer a “cold turkey” approach, introducing the carbon tax
without any special provision for transition, because it maximizes the
“anticipation effect,” which encourages businesses to start “behaving better”
immediately.[22] Others
agree that a bold and certain carbon policy should be announced as quickly as
possible, even if not immediately implemented, to allow businesses to make
their longer-term plans and investments with clear and strong price signals in
place.[23]

The
lack of global experience with comprehensive carbon taxes as well as the much
greater familiarity with permit systems in the United States as a market-based
environmental policy tool (and reluctance to adopt a major new “tax”) have led
some environmental policy experts to recommend a hybrid approach to reducing CO2
emissions—a cap-and-trade permits (or “allowances”) program with a “safety
valve” price mechanism. Under such an option, policymakers would set a cap on
carbon emissions and allow firms to buy and sell allowances among themselves,
but an upper limit on the market price of those allowances would also be established.
If the allowances proved scarce enough that the market price were bid up above
this upper limit, the government would sell as many additional allowances as
necessary (release the “safety valve”) to bring the market price back down to
that limit. Even if the initial allowances were distributed freely to
producers, the hybrid policy could be adjusted over time to move closer to the
tax policy by gradually setting tighter caps and correspondingly increasing the
fraction of allowances auctioned off by the government. With relatively
inelastic demand for allowances, safety-valve prices could also be gradually
increased to raise more revenue while achieving pricing that is closer to the
social optimum.

The
potential revenue from a carbon tax is substantial: the Congressional Budget
Office recently estimated that the range of carbon policies now being debated
suggests a market value of carbon allowances of between $50 billion and $300
billion annually.[24]
It should be noted, however, that a properly designed carbon tax, while
improving things from an environmental standpoint (by reducing activities that
produce CO2 emissions), would have a negative effect on overall
economic output. One recent study estimated that a
cap and trade program would reduce output in the long run by between 0.3
percent and 0.9 percent.[25]
To compensate for this decline, revenues
from the carbon tax should be used for policies that enhance growth. We believe
that a portion of the revenue from a carbon tax should be used to reduce other,
more distortionary, taxes, such as those on labor or capital income.[26]

In
addition to the potential negative effect of a carbon tax on economic growth,
another common concern about a carbon tax or cap-and-trade program is the
distribution of its burden. A carbon tax will generally raise the prices of
goods and services, with after-tax prices rising the most for those goods with
the highest carbon content. In some respects, a carbon tax may mimic a
broad-based consumption tax—a tax that tends to be “regressive” in incidence
because lower-income households consume larger fractions of their income.

Efforts
to mitigate the regressivity of a carbon tax should be implemented through the
overall tax system, particularly the income tax, rather than through exemptions
built into the carbon tax itself. This is both because the carbon tax is an
“indirect” tax levied on businesses and the carbon content of energy sources
they use, not a “direct” tax on households (and hence is too blunt an
instrument for redistributive policy), and because exempting certain parts of
the carbon tax base for distributional reasons would dilute the tax and thus
reduce its economic benefits.

The Political Moment for Bipartisan Tax Reform

The new
administration clearly has a lot on its plate, including developing an
effective economic stimulus package, dealing with the banking and housing
crises, and taking steps to address the unsustainable fiscal situation facing the
country. Wisely, it has already indicated that it plans to include fundamental
tax reform as part of its approach to fixing the economy and addressing the
long-term budgetary imbalances.

It
is relatively easy to agree about some of the major problems plaguing the tax
system, as well as the principles—simplicity, transparency, efficiency, and equity—that
should drive reform. It is more difficult, however, to come up with specific
policy proposals, particularly when bipartisan support is essential to a
successful reform package. We believe that the approach and specific policies
laid out here can serve as an excellent starting point for developing a
comprehensive, bipartisan proposal that would vastly improve our tax system.

[1] Robert Carroll is Co-Director of
the Center for Public Finance Research at American University and Vice
President for Economic Policy at the Tax Foundation. Buck Chapoton is the
Former Assistant Secretary for Tax Policy with the Reagan Administration. Maya
MacGuineas is the Director of the Fiscal Policy Program at the New America
Foundation and the President of the Committee for a Responsible Federal Budget.
Diane Lim Rogers is the Chief Economist at the Concord Coalition.

[4] There are a number of different
ways of taxing consumption. The most obvious approach is a national retail
sales tax. But other consumption-based taxes include a value-added tax, the
so-called Bradford X-tax, and a consumed-income tax. All of these alternatives
have identical tax bases, but differ with respect to who (e.g., businesses or
individuals) remits the tax to the government.

[6] To see this, one needs to
consider what each tax taxes and distorts. An income tax distorts the choice
between current consumption and leisure, and future consumption and leisure.
The latter distortion arises because an income tax taxes future consumption
that occurs through saving (i.e., savings today that is later consumed). In
addition, the income tax distorts the choice between consuming today and
consuming tomorrow (this is just the tax penalty on saving under an income
tax). A consumption tax also distorts the choice between consumption (both
current and future) and leisure. What is not often recognized in this type of
analysis is the fact that an income tax distorts the decision between future
consumption and leisure (just as an income tax). Even though the consumption
tax is imposed at a higher tax rate, only under rather strong assumptions would
a consumption tax not be more efficient than an income tax. For a discussion of
these assumptions see, for example, Alan Viard, “McMahon Off Base on
Consumption Tax,” Tax Notes, April
10, 2006; and David A. Weisbach, “The Case for a Consumption Tax,” Tax Notes, March 20, 2006.

[7] This concern may be overstated
to some extent because a substantial portion of the existing capital stock has
already benefitted from consumption-type aspects of the current tax system,
such as accelerated depreciation, and already trades at a discount.

[9] Ibid., 52. For example, the top
35 percent tax rate could be lowered to 23 percent and the bottom 10 percent
tax rate could be lowered to 6.6 percent.

[10] “Estimating the
Revenue Effects of the Administration’s Fiscal Year 2008 Proposal Providing a
Standard Deduction for Health Insurance:
Modeling and Assumptions,” Joint Committee on Taxation JCX-17-07 (March
24, 2007), Table 1, 20, available at www.jct.gov/x-17-07.pdf.
This estimate includes the exclusion for both income and payroll tax purposes.
About two-thirds of the subsidy arises from the income tax exclusion, while the
remaining third arises from the payroll tax exclusion.

[11] The effective cap is actually
somewhat higher, at $1.1 million, because taxpayers may also deduct interest on
up to $100,000 in home equity debt.

[12] The effective marginal tax rate,
derived from an estimate of the cost of capital, shows the share of an
investment’s economic income needed to cover taxes over its lifetime in order
to compare the investment climate across countries.

[13] A variety of
nontax factors, such as labor productivity, education levels, basic
infrastructure and transportation networks, access to markets, and the
regulatory environment, are also important to a nation’s competitiveness.
Absent clear evidence that the United
States has made major gains among the nontax
factors, its competitiveness has likely been adversely affected by its failure
to keep pace with the business tax trends abroad.

[14] William Randolph, International Burdens of the Corporate
Income Tax, Congressional Budget Office Working Paper Series, 2006–09,
August 2006.

[16] Wiji Arulampalam, Michael P. Devereux,
and Giorgia Maffin “The Incidence of Corporate Income Taxes on Wages,”
mimeograph, University of Warwick, September 2007; Kevin Hassett and Aparna
Mathur, Taxes and Wages, American
Enterprise Institute for Public Policy Research, Working Paper Number 123, June
2006; Alison Felix, “Passing the Burden: Corporate Tax Incidence in Open
Economies,” Ph.D. diss., University of Michigan, 2007, ch. 1.

[17] The major approaches for
eliminating or reducing the double tax include a dividend exclusion or lower
tax rate for investors, allowing a credit for corporate level taxes (imputation
credit system), or allowing a corporate deduction for dividends (dividend
deduction system).

[18] U.S.
Department of the Treasury, Approaches to
Improve the Competitiveness of the U.S. Business Tax System for the
21st Century, December 20, 2007, 27.

[20] Financial services should be
included in the tax base of either an income or consumption. The taxation of financial services, however,
can be complicated because of the “implicit fees” imbedded in interest rate
spreads, and generally would require a special regime to prevent over or under
taxation of consumers and businesses.

[24]Peter R. Orszag, “Issues in
Designing a Cap-and-Trade Program for Carbon Dioxide Emissions,” CBO Testimony
before the Committee on Ways and Means, U.S. House of Representatives,
September 18, 2008.

[25] See, Energy Information
Administration, “Energy Market and Economic Impacts of S. 2191, the
Lieberman-Warner Climate Security Act of 2007,” U.S. Department of the Energy,
April 2008, Table 4, 37. This reflects a range of estimated effects of
the Lieberman-Warner Climate Security Act (S. 2191) in 2020. The range of
estimates reflects different technological assumptions, the ability to use
international offsets to meet allowance requirements, and various other
factors.

[26] Recent estimates of industry
effects suggest that such a “modest” tax (of around $25 per metric ton of CO2)
would generate significant cost increases (on the order of 10 percent) for only
a few industries (such as petrochemical manufacturing and cement) and only in
the “very short run” where output prices cannot be changed and profits
therefore fall accordingly. The research concludes that although the short-run
output reductions would be relatively large in such industries, over time, as
firms adjust inputs and adopt new technologies, these industries would rebound
(some, virtually completely). See Mun S. Ho, Richard Morgenstern, and
Jhih-Shyang Shih, “Impact of Carbon Price Policies on U.S. Industry,” Resources
for the Future discussion paper (RFF DP 08-37), November 2008.